With yields back to levels not seen in over a decade, fixed income is experiencing a revival. Mike Wachter, Portfolio Manager and Head of Reinhart Fixed Income, shares his thoughts on the opportunity in bonds today.
Given the big move in rates last year, the inverted yield curve, and the volatility in the markets, where do you see opportunities in this environment?
Mike Wachter: For the last decade and a half, fixed income has been an incredibly challenged asset class. Rates had been kept low coming out of the Great Recession. There were points where the Fed started to raise interest rates, only to be forced to lower them quickly again – for example, during the pandemic. In general, without any yield in a portfolio, it is difficult to expect great returns from fixed income. That ended last year. We’re now sitting with yields in the 4.5% to 5% range in our portfolios. That yield that had previously been missing now provides investors with a base for solid returns. If interest rates do not change from here on out, you can expect a 4.5% to 5% return. That's a great starting level. Then consider the inverse relation between a bond’s price and rates. If interest rates were to move up from 4.5%, that yield would serve as a buffer against the negative price performance. If rates were to go down, you would get the 4.5% yield plus the additional price performance. All this considered, we think fixed income, as an entire asset class, is attractive right now.
When we started the year, there seemed to be a disconnect between what the Fed was planning and what the market was actually pricing in. Where do we stand today? And what are your expectations for rates moving forward?
MW: At the end of 2022 and into 2023, we started to see inflation moderating and signs of a slowdown in the economy. The market interpreted this as an indication that we may get rate cuts by the end of 2023, despite what the Fed has been saying about keeping rates higher for longer. Fast forward a month, we get a great nonfarm payroll unemployment report, retail sales are up 3%, and inflation data is stronger than expected. That flipped the market’s narrative on its head.
One thing I've learned in my 30-plus years as a fixed income investor is don't fight the Fed. That being said, I think that the Fed will do exactly what they are telling us they will do by continuing to raise rates. I don't expect them to stop until we get a fed funds rate north of 5%.
The big question is, will it have the effect that the Fed is looking for? Will it slow employment? Does it create more slack in the economy such that inflation will continue to come down? That’s what we’ll be watching for.
Let's get into the mechanics of bonds for a minute. Although yields in corporates and Treasuries are 4% to 5%, average coupons remain low in the 2% to 3% range. Can you comment on how investors will see their 4% to 5% return on these bonds?
MW: With market yields in the 4.5% to 5% range, no one would buy a bond with a 2% or 3% coupon unless you sell it to them at a discount. So, you ultimately achieve the higher market yield with the lower coupon level by accounting for the accretion of that discount towards maturity. For example, if I were to buy a five-year bond with a 3.5% coupon at a price of 95 cents on the dollar, over the course of that five years, I would add another 1% of yield on top of the coupon rate. It doesn’t work exactly like that, but conceptually, you buy a bond at a discount (95 cents) and are paid back at the full par value (1 dollar). The back-of-the-envelope math for this basic example would be: 3.5% coupon + 1% from the price going up each year = 4.5% yield.
Coming off a difficult year for both fixed income and equities, what is your message to investors on the role of fixed income in a portfolio?
MW: Even though both fixed income and equities experienced negative returns, fixed income returns, especially in intermediate high quality fixed income, were much better than equity returns. For example, high quality fixed income indexes were down single digits, while the S&P 500 was down over 18 percent. Looking forward, I think there is a real possibility of a recession in 2023. While this doesn’t always bode well for equities, we typically see lower rates in a recession, which could lead to decent fixed income performance. It’s also important to note that fixed income is starting the year with a yield in the four-plus percent range. So we are starting 2023 with a little bit of a head start and could potentially get even more return if rates are forced to go down, should we head into a recession.
The debt ceiling standoff has been in the news lately. What is your level of concern that this becomes a bigger risk? And are we making any portfolio changes because of this?
MW: If the United States were to default on its debt, it wouldn't be a calamitous event, and one that we really can’t plan for in a fixed income portfolio. I don't foresee this happening. Because of politics, we will continue to see headlines about it, but at the end of the day, I think the debt ceiling will be raised, and we will all go our merry way.
Mike Wachter, CFA is Portfolio Manager and Head of Reinhart Fixed Income